February 06, 2009

Is more effective international regulation the answer?

No, it is not.

I am prompted to write this by a piece in today's NYT, which centers around my colleague Ken Rogoff's views on financial globalization and its pitfalls. I think Ken is quite correct in his diagnosis of the problem, but I disagree with him on the policy implications that he draws.

This crisis has shown the Achilles’ heel of a globalized financial system to be a lack of high-quality, and consistent, regulation to prevent overconfident bankers from taking irresponsible risks. A year and a half ago, when it appeared to be a subprime mortgage issue for the United States, most countries thought they could glide past it. But it turned out that everyone in that globalized system was vulnerable to the collapse that began at the center.

“I believe we need a global financial regulator with real teeth,” Mr. Rogoff said this week, “to prevent the lowest common denominator problem.” Before this crisis, capital flowed to the place where it was least regulated, and some countries competed to be that place. It is worth remembering that the Bush administration was trying to use the threat of overseas competition to relax regulation before the financial system blew up.

If that doesn’t happen, then the most rational thing for many countries may be to insulate themselves from the globalized economy. “Countries will feel required to put on more capital controls so they are not exposed to countries that are taking risks,” Mr. Rogoff said.

That is absolutely right. But Ken's preference for a "global financial regulator with real teeth" overlooks three major problems. Global financial regulation is a bad idea because it is neither desirable, nor prudent, nor feasible.

It is not desirable because countries at different levels of development and with different national preferences with regard to how much risk they want to encourage as the price of financial innovation will want to select quite different national regulatory regimes. There is a large element of a "local public good" in the financial system, and you need to recognize the heterogeneity of national preferences.

It is not prudent, because a common global regulator will require global harmonization of rules. What if we converge on the wrong ones? That was one of the points brought out by Katharina Pistor recently.

Finally, it is not politically feasible because I just do not see that major countries will surrender national sovereignty to a global regulator with teeth. There is not enough political convergence globally for this to happen. But the major principled objections are the previous two, rather than this one.

What is the alternative? Ken is right that the only real alternative is a system of capital controls. But viewed in the context of the arguments I just made, it is not at all clear that a system that allows and legitimizes capital-account management would not dominate a futile and undesirable effort to set up a global regulator. In fact, the danger is that we will obsess on getting international regulation right with no plan B, and in doing so will simply prepare the groundwork for the next crisis.

But if we create a world of nationally segmented finance, won't we give up the benefits of global financial integration? Please.

Comments

There can never be uniform global rules because states have different goals.

One has only to look at the poor record of the UN in defusing military conflict to see this.

In general the developed states want natural resources from the less developed states at favorable prices. The developing states want trade policies that encourage local business and nobody cares what the undeveloped states want since they have no clout.

When it comes to relations between countries we are still operating at the level of the law of the jungle (might makes right). People get deluded because they see international mechanisms set up (IMF, WB, WTO, UN, etc) and think this is a sign of the rule of law.

It's only a sign that the strong states have found it more convenient to put a velvet glove on the iron fist.

I think that there is a choice in this. There is no international framework in place as of now, and national governments are going to do what they please, especially when they are coming under pressure from a full blown crisis.

Also, if national governments are put under more pressure to sign on to more international agreements at a time when 'globalization' as an end is becoming a very politically difficult sell (not that it wasn't before, but its even more so now), doesn't blowback become far more likely?

Let me put it this way. The first big experience in developing a framework for a global financial regulation was Basel, and most of the world is slowly realizing we would all have been better of had it never taken place.

To now extend the Basel regulation and to even have these as some propose to try to rate and cover systemic risks; as if anyone can truly be sure of what the current real dangerous systemic risk is; as if tinkering with discovered systemic risks will not increase the destructive power of any not discovered systemic risks, is plain lunacy or masochism.

Perhaps what could work is for the Bank for International Settlements ("BIS") to grade every country's prudential regulatory system. For example, the US and Iceland would (at least in hindsight) have received a low grade. This information could have been taken into account by German, Spanish and UK regulators in deciding how much capital banks in their respective countries must hold if they wish to invest in US and Icelandic assets. The subprime crisis would then have had less impact on the banks in Germany, Spain and the UK.

One benefit of this approach is that each country would have strong incentives to maintain strong prudential regulation so that its banks have cheaper access to overseas borrowings. It would be very important for the BIS to maintain its independence. Powerful countries like the US will likely pressure the BIS to award the highest grade to the US prudential regulatory system.

You say that it is not desirable because countries are different in economical development and goals. If I understand you properly you are against any international organisation, like world trade organisation (WTO). An organisation that involve all existing country exist and is agree by most economist as a good thing for the international commerce. Why should it be different for finance? It is totally possible for an organisation to understand the various level of development and adapt the risk profile to there need, while avoiding the Iceland syndrome.

You say it is not prudent because this organisation can have it wrong. This is the case for any organisation, did it stop us to make organisation: no! Also because this kind of organisation is multi-polar by nature different voice can be ear and errors can be corrected.

Finally you say that it is not politically feasible because states do not want to loose their prerogatives. The argument is also right for the WTO, but it has work for trade. Why should it different for finance? You are right there is a great resistant from states to loose this power, but now is the best time to have the discussion when states can feel the current crisis. The main point here is by giving away some area of influence states would understand that they are also removing area of influence of other possible rogue states.

The world of finance is already totally global; there is very little other human activity that is more global. We have seen during the current crisis that a few countries can have extremely strong impact on the rest of the world. Not regulating on a global level would be putting us in a world where this crisis can happen again.

I understand that a world finance organisation could over do regulation, but the very idea of global finance organisation is now a necessity. The argument that consist on saying it could not work or it will be difficult is not very convincing, given the fact that the alternative we are currently experiencing has already failed.

I'm from the Bahamas, in the Caribbean, and, capital controls is what is killing development.

For example, half of the Caribbean offer financial services. However, they are only services in the administrative sense--fiduciary and trust companies, primarily.

These vocations are not very lucrative and we can't move forward towards more financial innovation, if there are capital controls--especially since buying foreign owned stocks, comes with a tax of nearly half of the income. Also, especially, if we tax capital that comes in and is virtually trapped when they are here.

It's easy to get it in, but costs allot to get it out.

It's not feasible-- with still too many risks-- so folks just don't use the stock market at all and domestic "financial advisors", are stuck with one or two options in the financial services internationally and domestically--real estate (domestic) and fiduciary and trust services (offshore clients).

Forget about local bourses....its pathetic, because we don't have the technical expertise, to help innovate, when there is no framework in place, to guide that innovation because it is not needed.

So, everyone is stuck doing the same thing, with little thought on moving forward, because it costs too much to even think about--let alone move forward with.

I would LOVE to see the financial markets in the devloping countries, truly develop. However, with capital controls, this is would never happen.

I am currently writing a book on the irrationality of global tax competition and was struck by the similarity of arguments used by prof. Rogoff and Rodrik to those used in the tax competition debate: there it is argued that a World Tax Organization "with real teeth" would be desirable (to paraphrase Rogoff) “to prevent the race to the bottom problem. Before this crisis, capital flowed to the place where it was least taxed, and some countries competed to be that place". Prof. Rodrik provides arguments usually used by proponents of tax competition. Would he argue the same in the tax competition debate?

Dani Rodrik argues that effective international regulation of global finance is impossible, for essentially two reasons. Because not enough people want it yet and, anyway, there are too many political obstacles to effective regulation from those who prosper from the chaos.

Scope for negotiation? A start could be made with the effective regulation of finance nationally. The 'Economist', for example, has complained: "For all the benefits of greater international co-operation, though, the most important regulatory lessons from this crisis lie at home. . . it is domestic reforms that will yield the greatest returns." And "In a fight, the regulators have the legal power. But the financiers have the political power".

I get Rodrik's point, however I'm just saying that it [capital controls and stiff financial regulation by means of heavy taxation] would impede the diffusion of information for development.

At worse, it would concentrate the money into the hands of the persons who have the most. Who, by all accounts, have been the bigger part of the problem--the problem is not the money, but the people who weild it!

Unfortunately there is still no common EU position on regulation. So, for the meantime, each government will be expected to continue tightening its own financial controls. A move to make audit independent from national politics would certainly remove many complaints and honour its professionalism.

Youri, having improved regulation and solved trading imbalances, attention might eventually focus on tax havens. The heads of many big states in the West have criticised tax havens: President Obama, when he was the senator from Illinois, joined two other senators in introducing the "Stop Tax Havens Abuse Act" in the US Congress - the Act never became law; the president of France said last week his country will review its relations with neighbouring financial havens such as Luxembourg, Andorra and Monaco; and the BBC reported claims that the British government "is broke - a record £44b in the red - and yet one estimate is that the taxman loses £18.5b a year thanks to tax haven abuse".

"The metaphor that comes to mind is that of a large ship. A single-hull ship will cost less to build and operate than a similar ship with a double hull. It will therefore earn more money on every trip, but it is more likely to be sunk if it encounters a severe storm or large iceberg."

Wrong metaphor. The one I would chose is that of a monoculture. A monoclture is very susceptible to a single disease, which can sweep through and decimate it. A polyculture, though, is relatively resistant to a disease, and a disease outbreak, when it occurs, will not result in catastrophic crop failure, but a partial and much more localized one.

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The Basel Committee, responding to its absolute failure in trying to avoid a crisis by means of creating disincentives for banks to assume credit risks as measured by others, is now slowly evolving into the believing they could and should measure and fight systemic risk. This is indeed a truly scary example of cognitive dissonance.

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